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Developed markets a better bet as inflation threat hits EM returns

By: Elliot Farley | 29 Mar 2011

We have spent much of the past ten years extolling the virtues of the longer-term outlook for emerging markets.

However, more recently we have found ourselves in the position of arguing that, for the shorter term, better value lies in some of the developed markets.

The growth outlook for EMs now looks less rosy in the light of burgeoning inflation threats, and we do not see this as being conducive to the region performing relatively so well in the short term. In comparison, some developed markets such as the US offer more attractive value and, in their case the dollar, has scope to rise this year too.

In the UK, the government’s commitment to fiscal tightening seems like unpleasant but necessary medicine that should strengthen the economy in the long run. The response of many corporates to the financial crisis was to cut out inefficiencies, reduce labour costs and hoard cash. This has left them in a much stronger position to benefit from future economic growth. Japan has begun to contribute positively to performance in our portfolios. We consider Japan’s deficit and debt burden untenable in the long run. Perhaps one of the more politically acceptable routes out of this problem is through monetary expansion, devaluing the yen and inflating a path out of debt.

This is not an attractive proposition for holders of Japanese debt, but it would add to the relative attraction of Japanese stocks. Partly in anticipation of this scenario unfolding, we have a meaningful exposure to Japanese equities, although of course we are hedging the currency risk, which otherwise jeopardises any potential gains.

Of the other developed markets, Europe is the one area where we remain negative. The recent Irish election and discussion around renegotiating bailout terms are reminders to any who have put to the back of their minds the risk of eurozone.

More generally, risks around sovereign debt, coupled with the inflationary environment mean government bonds at their current rates do not offer enough reward. Given the risks sovereigns have taken on in the wake of the financial crisis, and the desire of governments to stimulate growth, we continue to be extremely underweight in our exposure to this asset class.

Investment grade bonds, similarly, do not look attractively priced, but we feel value can be found within highyield debt. So, in the fixed income space, we favour high-yield and strategic bond funds, which have the ability to identify opportunities across the breadth of fixed income asset and the ‘toolkit’ to respond to rising rates.